<<

. 59
( 62 .)



>>

Not the Issuer)
A common assumption is that shares issued in a public offering (whether
done via SCOR or Reg. A) will be freely tradeable under state and federal
law. Although shares issued in these types of offerings are not “restricted” se-
curities under federal law, blue sky laws of various states (most notably
California) can limit the ability of shareholders to resell their shares.
When the California Department of Corporations imposes suitability re-
quirements on the investors who buy shares in an offering, the Department
almost invariably adds a restriction on the use of broker-dealers for second-
ary trading of those shares. Essentially, broker-dealers are not allowed to so-
licit customers to purchase these shares. Instead, these shares may be
transferred only under certain limited circumstances, such as:

1. In a private sale to another person.
2. By a broker-dealer in an unsolicited transaction (where the purchaser
initiates the contact, not vice versa).
3. Sales taking place in another state where the trade is permitted.
352 APPENDIX B


Under recent amendments to federal and California securities laws,
many of these restrictions have been eliminated for reporting companies.
However, because many companies that sell stock pursuant to public offer-
ings under SCOR or Reg. A are not generally reporting companies (in fact,
they cannot be reporting companies if they use SCOR or Reg. A), these re-
strictions will continue to apply for those companies.
In some cases, the Department of Corporations may place additional
limitations on the transfer of shares issued in public offerings as well. Thus,
in California, one must not assume that shares issued in a SCOR or Reg. A
offering will be freely tradable through the use of broker-dealers; oftentimes
they are not.


7. THE INTERNET

7.1 In General
Surprisingly, the regulators, federal and state, do not oppose (they actually
encourage) the use of the Internet as a vehicle for the sale of securities.
The reason for their enthusiasm is rather obvious: It is easy to monitor
the Internet, certainly easier than the telephone or the mails. This is enforce-
ment made easy. In addition, the regulators appreciate that for the first time
there is an inexpensive vehicle that can be used by small and emerging com-
panies to raise capital. The capital “gap” between $250,000 and $5 million
may be bridged for the first time by the use of the Internet.
The use of the Internet for selling securities is a cutting-edge issue. Those
involved, both private and government, are feeling their way. Direct public
offerings (without an underwriter) on the Internet promise to be a very good
source of financing for small business.
A brief rundown on how it works would be:

1. The electronic prospectus (U-7, Reg. A Offering Circular, SB-2
Prospectus) must provide the same information as a written prospec-
tus. The “electronic prospectus” is really an ordinary disclosure docu-
ment usually sent by e-mail to the potential purchaser.
2. If there is a suitability issue, the issuer must question (Offeree
Questionnaire) the potential investor to establish suitability prior to
accepting any funds.
3. Electronic means (e-mail) may be used to transfer documents. (This
saves considerable funds due to lower printing costs.)
4. The issuer must have qualified or have an exemption in the jurisdic-
tion in which the purchaser resides.
353
Legal Primer on Securities Law Issues for Nonlawyers


In California the Internet can be used in a private placement, subject to
strict rules. [See California™s Section 25102(n) analysis.] In most states, if the
Internet is used, a private placement is not possible.


7.2 The Offer
Traditionally, one was not allowed to offer (let alone sell) in a jurisdiction
without qualification or exemption. The Internet, of course, does not respect
state or country lines; this means an offer in one state becomes a universal
offer. To cope with this, the states are either ignoring the issue or considering
the issue or adopting laws and regulations that permit offers without quali-
fication as long as the offer is accompanied by “disclaimer” language that
states, in effect, “This is not an offer in any jurisdiction where it has not been
qualified. No sale may be made within any state unless pursuant to qualifi-
cation or an exemption from Qualification.” California has accepted
the concept of allowing Internet offers that contain the legend or disclaimer
just noted.


7.3 Suitability
In the event suitability is imposed by the commissioner, the offeror must ob-
tain a completed offeree questionnaire establishing the investor™s suitability
prior to accepting any investment funds. Again, this may be done using e-mail
to send the questionnaire.


7.4 The Sale
A sale may not be made without qualifying or being exempt in the jurisdic-
tion where the sale is being made.
The Internet, in effect, allows one to “test the waters” by seeing how
many inquiries one gets from the Internet exposure. If 50 inquiries come
from Texas, one had better qualify to sell in Texas.
Of interest, the purchaser may use a credit card to pay for the his or her
security.


8. FEDERAL/STATE

Subject to its abdication in SCOR offerings, the federal government has ju-
risdiction if any offers (usually ignored) or sales are made in more than one
state. The use of the Internet is an example of ignoring offers because one
354 APPENDIX B


simply says, “This is not an offer in any state where not qualified,” and the
“offer” becomes a “nonoffer.”
For small offerings one usually uses the private placement exemption
provided by Section 25102(f) and offers in California (or one™s resident state)
only.
If more than one state and over $1 million, the federal government as-
serts jurisdiction. So does each state. One must blue sky (clear) both private
and public offerings in each state. A new program, Coordinated Equity
Review, promoted by NASAA, involves two lead states handling the clear-
ance for all states. One state coordinates the merit review states and the other
state coordinates the full disclosure states.
California has joined. Such review is limited to SB-2 offerings and
above. The process eliminates “suitability” in California. Blue skying is la-
borious and expensive. Caveat: The Coordinated Equity Review process has
evolved into an undesirable route because it has resulted in too many restric-
tions being tagged on by each of the involved states, some of which the issuer
may not even wish to be qualified in. Better to blue sky (qualify) only in those
key states that appear the most promising for fund raising.


9. THE ™40 ACT
The Investment Company Act of 1940 controls mutual funds. If a fund has
over 100 owners, it comes under the ™40 Act.
The ™40 Act is infamous as being extremely restrictive and is one of the
primary reasons venture capital is confined to relatively few very wealthy in-
dividuals and institutions: a “cartel of capital.” The venture capital firms
wish to avoid the ™40 Act and thus have few investors.
SBICs with more than 100 owners come under the ™40 Act. That is the
primary reason there are very few (less than ten) publicly owned SBICs in the
United States.
Congress, in its last session, passed laws providing for two types of
closed-end and single state funds that are exempt from the ™40 Act.
The first category is that of economic, business, and industrial develop-
ment companies. They must be regulated under state law. Eighty percent of
the funds must come from persons residing in the state, and only accredited
investors may invest (unless the SEC changes the rules, which Congress said
it could). Until September 19, 1998, California had a regulatory law that
was extremely burdensome. Thanks to the efforts of attorney Lee Petillon
with the backing of the California Capital Access Forum, a new law
(SB2189) was enacted, which provides a more usable regulatory scheme in
355
Legal Primer on Securities Law Issues for Nonlawyers


California. This new law should result in California spawning many new
business development companies. It is hoped other states will also encourage
such activity.
The second category that is exempt from the ™40 Act is simply Congress
authorizing the SEC to exempt by rule or order closed-end funds that are in-
trastate in their source of funds with a maximum of $10 million or “such
other amount as the SEC may prescribe by rule, regulation or order.” There
are no prescribed standards as to investors or type of investments. One ap-
plies to the SEC for an exemption. This is a promising opening for raising
funds to finance small business. It should catch on.
Venture capital funds have successfully dodged the Federal Investment
Advisors Act; it appears they do not fall under the state™s rules regarding in-
vestment advisers. The “blind pool” prohibition rule applies only to public
offerings and to Section 25102(n) solicitations.


10. THE USUAL

Usually, in California, a start-up or growing company will utilize Section
25102(f) to raise seed money privately. This is followed by a SCOR or Reg.
A offering, keeping the integration rules in mind.
As an alternative, if the entrepreneurs know a number of accredited in-
vestors (angels) or are seeking venture capital financing, Rule 506 works well,
and it avoids the blue sky issue (other than state fees and a Reg. D filing).
Also, Rule 506 avoids the integration problem of a possible six-month wait.
The next stage is either a Reg. A (public up to $5 million) or an SB-2; the
latter results in the issuer becoming a reporting company (10Ks, 10Qs, and
now Sarbanes-Oxley Act compliance”very expensive).
The question of establishing markets for the stock deserves a separate
primer. Suffice it to say there is much misunderstanding regarding market
makers, what they do, when, and why. Responsible liquidity does not hap-
pen overnight unless there is an investment banker (underwriter) managing
the effort.


11. SALES””AGENTS” (CALIFORNIA)

A question frequently asked is: Who can sell our offering?
If private: Officers and directors can all sell as long as they are not com-
pensated in relation to the sales of securities. Third parties may sell only if
they are not compensated.
356 APPENDIX B


If public: Unless a licensed broker dealer, an officer or director may sell
if not separately compensated for the sale. If separate compensation (officer
or director) or third-party “agent,” must have a $10,000 bond or post assets
with the Commissioner of Corporations. An “agent” is described in Section
25003 of the Corporations Code; the bond requirement is in Section 25216
(Rules Section 260.216.15).
Suggested Reading List


Alarid, W. ( 1991). Money Sources. Santa Maria, CA: Puma Publishing.
Amis, D. (2001). Winning Angels. New York, NY: Prentice-Hall.
Anderson, J. (2000). Cybervaluation. Washington, DC: Bond & Pecaro.
Benjamin, G. & Margulis, J. (1996). Finding Your Wings: How to Locate
Private Investors to Fund Your Venture. New York, NY: John Wiley &
Sons.
Benjamin, G. & Margulis, J. (2000). Angel Financing: How to Find and
Invest in Private Equity. New York, NY: John Wiley & Sons.
Benjamin, G. & Margulis, J. (2001). Angel Investor™s Handbook. How to
Profit from Early-Stage Investing. Princeton, NJ: Bloomberg Press.
Bergan, H. (1992). Where the Money Is. Alexandria, VA: BioGuide Press.
Blum, L. (1995). Free Money. New York, NY: John Wiley & Sons.
Broce, T. (1979). Fund Raising. Norman, OK: University of Oklahoma
Press.
Burlingame, D. (1991). Taking Fund Raising Seriously. San Francisco, CA:
Jossey-Bass.
Camp, J. (2002). Venture Capital Due Diligence. New York, NY: John Wiley
& Sons.
Chimerine, L., et al. (1987). Handbook for Raising Capital. Homewood, IL:
Business One Irwin.
Coveney, P. (1998). Business Angels. New York, NY: John Wiley & Sons.
Evanson, D. (1998). Where to Go When the Bank Says No. Princeton, NJ:
Bloomberg Press.
Field, D. (1991). Take Your Company Public. New York, NY: New York
Institute of Finance.
Fisher, D. (1989). Investing in Venture Capital. Charlottesville, VA: Institute
of Chartered Financial Analysts.
Henderson, J. (1988). Obtaining Venture Financing. Lexington, MA:
Lexington Books.
Gladstone, D. (1988). Venture Capital Investing. Upper Saddle River, NJ:
Prentice Hall.
Gupta, U. (2000). Done Deals. Boston, MA: Harvard Business School Press.
Helfert, E. (1991). Techniques of Financial Analysis. Homewood, IL:
Business One Irwin.


357
358 SUGGESTED READING LIST


Hill, B. (2001). Inside Secrets to Venture Capital. New York, NY: John Wiley
& Sons.
Hill, B. (2002). Attracting Capital From Angels. New York, NY: John Wiley
& Sons.
Holben, C. (1996). California Small Business Access to Equity Capital.
Sacramento, CA: Trade and Commerce Agency Report.
Howe, F. (1991). The Board Member™s Guide to Fund Raising. San
Francisco, CA: Jossey-Bass.
Keely, R. et al. (1998). Business Angels. Boulder, CO: Colorado Capital
Alliance.
Kozmetsky, G. (1985). Financing and Managing Fast-Growth Companies.
Lexington, MA: Lexington Books.
Kramer, M. (2001). Financing and Building an E-Commerce Venture.
Paramus, NJ: Prentice Hall.
Lindsey, J. (1989). Start-Up Money. New York, NY: John Wiley & Sons.
Lindsey, J. (1990) The Entrepreneur™s Guide to Capital. Chicago, IL: Probus
Publishing.
Lipper, A. (1996). Guide for Venture Investing Angels. Columbia, MO:
Missouri Innovation Center.
Lister, K. et al. (1995). Finding Money. New York, NY: John Wiley & Sons.
Long, M. (1998). Raising Capital in the New Economy. San Diego, CA:
ProMotion Publishing.
Long, M. (1998). Unlimited Capital. San Diego, CA: ProMotion Publishing.
May, J. (2001). Every Business Needs an Angel. New York, NY: Crown

<<

. 59
( 62 .)



>>